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Chapter 29 Government

Chapter 29 Government Regulation of Business The basic economic problem is scarcity. Human wants are unlimited. Resources are limited. The basic goal in dealing with the problem of scarcity is to produce as much consumer satisfaction as possible with the limited resources available. In the U.S. economy, this goal is pursued primarily through private markets. Private markets have many positive attributes. We saw in Chapter 3 that in a private market the market price will automatically adjust to equilibrium, eliminating any surplus or shortage. A competitive private market generally reaches equilibrium at the most efficient quantity of output (where marginal social benefit and marginal social cost are equal). In a private market, the equilibrium quantity is generally the quantity that maximizes the net benefit of having the market available (i.e. maximizes the sum of consumer’s surplus and producer’s surplus). In private markets, competition forces producers to respond to consumer demand. And competition forces private market producers to use their limited resources efficiently. Production will be allocated to the producers who can achieve the lowest cost of production. Private markets also contribute to maximum individual freedom. In private markets, consumers are free to pursue their self-interest (utility-maximization). And producers are free to pursue their self-interest (profitmaximization). But private markets are not flawless. We saw in Chapter 27 that market failure occurs when the market does not produce the optimal quantity of output. Market failure may occur for various reasons (lack of perfect competition, externalities, public goods, common goods, asymmetric information, etc.). Government regulation of business may be aimed at correcting market failure and improving economic efficiency. An example of this is government regulation of natural monopoly. Government Regulation of Natural Monopoly Natural monopoly was introduced in Chapter 22. Natural monopoly results from extreme economies of scale. Economies of scale occur when a firm’s average total cost decreases as the scale of its operation increases. Economies of scale usually occur when fixed costs are very large (e.g. the cost of running natural gas lines throughout a city). Once the fixed costs are incurred, average total cost will decrease over a large range of output. If average total cost decreases over the entire market demand for an industry, the industry will be a natural monopoly. Natural monopoly – an industry in which economies of scale are so important only one firm can survive. Example 1: If the annual market demand for widgets is 100,000 and the minimum efficient scale of operation is a factory large enough to produce 100,000 widgets per year, the widget market is a natural monopoly market. Only one firm will be able to survive in the market. If more than one firm initially enters the widget market, whichever firm gains the largest market share will have a competitive advantage over all the other (smaller) firms in the market. The largest firm will be operating at a lower average cost of production, since it is producing at a lower point on the downward sloping average total cost curve. It will be able to charge a lower price and will thus gain additional market share. The increased market share will increase its cost advantage over the other firms. Eventually, the larger firm will drive the smaller firms out of the market. Only one firm will survive in a natural monopoly market. FOR REVIEW ONLY - NOT FOR DISTRIBUTION A natural monopoly may be regulated by government or may be unregulated. An unregulated natural monopoly would attempt to maximize profits. Profit-maximization would be achieved by following the profit-maximization rule for producing output (produce the quantity of output where marginal revenue equals marginal cost). Unfortunately, the profit-maximizing quantity of output is 29 - 1 Government Regulation of Business

not the same as the optimal (most efficient) quantity of output. The profit-maximizing quantity of output (the quantity of output where marginal revenue equals marginal cost) is less than the optimal quantity of output (the quantity of output where marginal social benefit equals marginal social cost). The optimal quantity of output occurs where price equals marginal cost. As we saw in Chapter 21, the quantity where price equals marginal cost is also the quantity (assuming no externalities) where marginal social benefit equals marginal social cost. If an unregulated natural monopoly produces the profit-maximizing quantity, this will cause a deadweight loss. The deadweight loss is equal to the area between the demand curve and the marginal cost curve for the quantity of underproduction. The quantity of underproduction is the amount that the profit-maximizing quantity of output (where marginal revenue equals marginal cost) is less than the optimal quantity of output (where price equals marginal cost). Example 2A: The graph below illustrates the demand curve (D), the marginal revenue curve (MR), the average total cost curve (ATC), and the marginal cost curve (MC) for a natural monopoly. (Note that the average total cost decreases over the entire market demand.) If this natural monopoly is unregulated, it will attempt to maximize profits. The profit-maximizing quantity of output (labeled Q UN ) occurs where marginal revenue equals marginal cost. $ P UN P OPT $8 - 7- 6- 5- 4- 3- 2- 1- Deadweight Loss 0 0 10 20 30 40 50 60 70 80 90 100 Q D = P UN Q OPT MR Quantity (thousands) MC ATC The profit-maximizing quantity of output (where MR equals MC) is 50,000 units. The profitmaximizing price (labeled P UN ) is indicated by the demand curve, and is $6. To sell 50,000 units of output, the firm can charge a price of $6. At the profit-maximizing quantity, the price ($6) is greater than the average total cost (slightly more than $4), and thus the firm would earn an economic profit. The optimal quantity of output (labeled Q OPT ) occurs where price equals marginal cost (and thus where marginal social benefit equals marginal social cost). The optimal quantity of output is 80,000 units. FOR REVIEW ONLY - NOT FOR DISTRIBUTION The deadweight loss is highlighted on the graph and is equal to the area between the demand curve and the marginal cost curve for the quantity of underproduction. The quantity of Government Regulation of Business 29 - 2